With the lowering of C corporation tax rates, several clients have asked about corporate structure. In the past, the best choice was almost always an S corporation. But, the new tax law has made it a more difficult question to answer. There are a lot of factors that play into the decision.
Many farms were incorporated as C corps in the 1960s, 70s and 80s. At the time, the highest corporate tax rate was lower than the individual rate, and C corps allowed farmers to deduct personal expenses such as housing. However, there was a price to pay. Land contributed to a C corp was trapped; the corporation had to pay tax on profits, and the shareholders paid tax on the dividend distributions or, ultimately, liquidation gains (double taxation). However, until 1986, there was an opportunity for closely held C corporations to liquidate without the double tax. That door closed more than 30 years ago.
Rate Changes. After the 1986 Tax Reform Act, individual tax rates went down. Many farmers looked at converting to an S corp to avoid the double taxation, especially at retirement. This was especially the case if the stockholders were no longer living on the farm. Pass-through income tax treatment and reduction of self-employment tax were a big draw to farmers. But, with the 2018 tax law changes, people have begun to ask if C corps were making a comeback.
Starting in 2018, the tax rate for C corporations is a flat 21%, and the highest individual rate is 37%. In addition, dividends from a corporation are taxed at 0, 15 or 20% (depending upon the stockholder’s level of taxable income), and they are subject to the net investment income tax. Almost always, the tax rate paid by S corporation shareholders will be less than the combined tax rate on a C corporation paying dividend.
Qualified Business Income. In the new law, the Section 199A deduction for qualified business income only applies to pass-through entities, not C corps. The deduction is subject to limitations, however (see “Section 199A Fix Update” in the May 2018 issue). This effectively puts the top tax rate on qualified business income earned by an S corp as low as 29.6%.
However, if you want to convert a C corp into an S corp, there is a hidden wrinkle called the built-in gains (BIG) tax. For five years after the S election is made, the shareholders recognize additional tax on the gain that was on the books as of the date of the switch. The BIG tax can be mitigated with proper planning.
Tax Attributes. Another issue with changing to an S corp is the loss of certain tax attributes. If the C corp had a net operating loss, it can only be used to offset the BIG tax after the switch. Excess would be suspended until the S corp converted back to a C corp. S corp shareholders may not be able to use prior-year losses generated by the corporation when it was a C corp.
There are other considerations when looking at a conversion to an S corp. For example, S corp losses can be used to offset other personal income (subject to some limitations), whereas C corp losses can only offset future C corp profits. Also, Schedule K-1 income from S corps is not subject to self-employment tax.
So, what is the best entity choice? For the majority of my farm clients, it’s the S corporation. The exception is the smaller farm corporation that provides tax-free housing to its shareholder-employees.
Tax Columnist Rod Mauszycki is a CPA and tax partner with the accounting firm of CliftonLarsonAllen, in New Ulm and Minneapolis, Minnesota.
Read rod’s “Ask the Taxman” column at about.dtnpf.com/tax.
You may email Rod at email@example.com.
Copyright 2019 DTN/The Progressive Farmer. All rights reserved.